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The Best Thing Apple Can Do With its Cash

Andrés is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Hedge fund manager David Einhorn has made a lot of waves recently by urging Apple (NASDAQ: AAPL) to put its cash to better use. Einhorn is right in pointing put the fact that the company is mismanaging its assets by keeping an enormous amount of cash in low-return investments as opposed to unlocking that value in the benefit of shareholders.

His proposal regarding that money is certainly smart and innovative, but I have a better idea: Apple should simply implement a big fat buyback program.

The Cash Problem

Apple has more than $137 billion in balance sheet cash; this is more than enough to go through any difficulties that may arise in the future, especially considering that the company generates tons of free cash flows on a quarterly basis. This is an inefficient use of the shareholders' capital, and it needs to be worked out.

Einhorn's idea of issuing preferred stock at no cost to current investors makes a lot of sense from the point of view of a financier. It would be tax efficient and take advantage of the market's appetite for yield while preserving operating and financial flexibility, like the hedge fund manager said in his letter.  From a financial perspective, this would be a far more efficient use of capital than the current strategy of simply hoarding cash.

Others like Jim Cramer disagree with this idea. Cramer thinks that Apple should go shopping for growth with that money, buying a company like Netflix (NASDAQ: NFLX), for example. Such an acquisition could benefit both companies, and many investors would prefer that road over preferred shares.

Netflix could certainly profit from a partnership with Apple and its enormous financial resources. The company is under financial pressure to acquire content and continue building its competitive strength in streaming, so it could give a very good use to all that money. Besides, joining forces with the most successful hardware company in the last decade could have plenty of strategic value for Netflix, facilitating for example its access to Apple's gigantic user base.

Apple could gain a leadership position in the exciting online streaming business, which could ease recent concerns regarding slowing growth for the Cupertino giant. Jim Cramer and others would like to see Apple reclaiming its place as a leading growth stock, not a value play with attractive dividends.

Apple is not prone to big acquisitions, and even if it wanted to buy Netfilx it would still have more than enough cash to pay for the deal and return cash to shareholders. At a market cap below $10.2 billion for Netflix, Apple has enough cash to pay a considerable premium to market value, finance content acquisition and still reward its shareholders with cash distributions.

The debate is quite interesting as it points out the differences among those who view Apple as a growth stock that should make exciting acquisitions to remain at the forefront of business innovation and value investors who focus on the efficiency of capital allocation and shareholders' return. But there is a better solution.

Listening to Buffett

Back in 2010 Steve Jobs met with Warren Buffett in a search for advice about what to do with Apple's already big and rising cash balances. Buffett explained to Jobs that, in case he felt that the stock was undervalued, a buyback would be a good idea.

This is a basic but powerful concept: when a company is repurchasing its own shares at a convenient price, it's not only reducing the share count and increasing earnings per share, it's also putting the company's cash to work in a profitable investment. This is a double benefit for investors.

Unfortunately, Steve Jobs believed the shares were cheap, but he didn't listen to Buffett. The stock was trading between $200 and $300 per share in 2010, so Apple would have made a fantastic investment buying its own stock that price.  At a P/E ratio below 11, Apple is dirt cheap at current levels, so the market is giving the company another chance to repurchase its shares at a very convenient price; let's hope Tim Cook doesn't let this one go too.

Speaking about Buffett, Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B) provides an excellent model for Apple to replicate when it comes to stock repurchases. The Oracle of Omaha knows a thing or two about capital allocation, and he has designed for Berkshire what is arguably the most efficient and transparent repurchase program around.

Berkshire will repurchase stock under two conditions: the shares must be trading at an attractive valuation – which Buffett has defined as a price to book value ratio below 1.2 – and the company must have more than $20 billion in cash at hand for different uses. This provides clear and objective measures regarding the convenience of the program, and investors in Berkshire can feel comforted on the fact that the company won't repurchase stock unless it's in their best interest.

Berkshire's buyback strategy is simple and smart: if you have more cash than needed, and the stock is undervalued, a buyback is the way to go. Apple evidently has more cash than it could possibly spend, and the stock is trading at historically cheap valuation levels, so there are some fairly strong reasons to put that money to work in an investment opportunity like Apple itself.

Bottom Line

Einhorn is right about Apple's necessity to put its money to work in something better than low-yielding securities, but considering how undervalued the stock currently is, a buyback should take priority over all other alternatives.  

 


acardenal owns shares of Apple and Berkshire Hathaway. The Motley Fool recommends Apple, Berkshire Hathaway, and Netflix. The Motley Fool owns shares of Apple, Berkshire Hathaway, and Netflix. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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